Why lashing governments to the mast will always prove futile

by John Kay

Financial Times
February 21, 2012

The Greek leader Odysseus ordered sailors to tie him to the mast so he could resist the song of the sirens. This kind of commitment strategy makes it costly to deviate from a policy one might not have the will to execute.

Such strategies are essential to modern economic life. Households and businesses are able to engage in complex transactions because they are able to restrict their future behaviour. They can do so by investing in their reputation; they incur contractual obligations that put them under the jurisdiction of the courts. The establishment of effective mechanisms that restrict opportunism and allow costly commitments may be the most important distinction between rich and poor countries.

Commitment strategies have also played a key role in the development of modern macroeconomic theory and policy. The paradigm of rational expectations supposes that companies and households have the same insights into the future as the government itself. If all agents use this shared knowledge as a basis of action, government policies should lay out sustainable paths for fiscal and monetary growth and thus enable everyone to make plans on a consistent basis. Such thinking has provided a rationale for central bank independence, inflation targeting and for an approach to fiscal policy that involves binding debt and deficit targets. The regulatory “fine tuning” of taxes and expenditures that was characteristic of the Keynesian hegemony has been abandoned.

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